The Truth About Inflation…

While BP PLC (NYSE ADR: BP) closed in this week on finishing relief wells to permanently plug the oil spill, stormy weather threatened to delay the final steps as clean up crews were called in to shore.

BP capped the blown-out Macondo well last week and has been conducting pressure tests to ensure the cap’s strength. A relief well is close to completion but work has been halted until the storm passes. All work could be stopped for 10 – 14 days if the area is evacuated.

While the leak may finally be close to plugged, the financial aftermath is far from over. Corporate entities and the U.S. government continue to point fingers at each other.

The results of Europe’s bank stress tests are due July 23. But the question remains whether the tests will shed enough light on the banking sector to restore investor confidence.

“All these stress tests mean that we are peeling away layers of the onions, but chances are we are not going to get the full clarity that we as investors deserve," Neil Dwane, chief investment officer for Europe at equities specialist firm RCM, told The New York Times.

Readers who are already on guard from Wall Street manipulation and stalled financial reform have pulled back from volatile markets and are skeptical about the effectiveness of bank stress tests:

A New York Post article in May reported that the Department of Justice had launched an investigation into the supposed metals-market manipulation by JPMorgan Chase & Co. (NYSE: JPM).

The article alleged that JPMorgan, which holds a number of derivatives in precious metals, attempted to lower the price of silver for its own profit. JPMorgan was quick to issue a response, stating there was no criminal or civil investigation into the company’s silver trading practices.

But as word spread around the Web, readers’ comments poured in with concerns over the news:

The global energy sector is shifting which means huge changes lay ahead for the U.S. natural gas market. Dr. Kent Moors, a career energy-sector consultant who works with governments and corporations throughout the world, says the United States’ fragmented natural gas market is “about to become one global market, operating at the speed of light.“

U.S. natural gas will play a major part in reducing greenhouse gas emissions by replacing older, inefficient coal plants. Its use is likely to double to 40% of the energy market over the next several decades, according to a study by the Massachusetts Institute of Technology.

The abundance of natural gas – especially shale gas, an unconventional source packed tightly in rock formations – in the United States has driven down natural gas prices, making the fuel more desirable. Shale gas has grown to 15%-20% of the U.S. natural gas output, and as companies design better drilling technology, shale gas reserves will be more easily attainable.

“Natural gas is becoming sexy again, with all this new technology to get the gas out of the shale,” Kim Hill, director of the Sustainable Transportation and Communities group for the nonprofit Center for Automotive Research told The New York Times.

Administration officials announced this week that the White House Budget Director Peter Orszag plans to leave U.S. President Barack Obama’s Cabinet before work on the next U.S. budget begins, which could be some time in the next few weeks. Orszag would be the first member of President Obama’s Cabinet to exit.

The U.S. budget is under scrutiny as the budget deficit is forecast to hit $1.6 trillion by 2011. A President-appointed panel is currently working on budget reduction plans to be presented in a report due in December.

Orszag’s strategies as former head of the Congressional Budget Office (CBO) supported a stop to deficit spending, but once he was placed in the budget driver’s seat, making significant cuts was nearly impossible with recovery progress slow and unemployment high. Orszag instead ended up helping outline the $787 billion stimulus package in 2009.

The Financial Accounting Standards Board (FASB) last month proposed an overhaul of accounting standards that would require U.S. banks to record their loans at current market value, giving investors a clearer picture of the banks’ financial standing.

The proposal is an effort to tighten banking regulation and improve financial transparency, and coincides with Congress finalizing financial reform.

News of the possible policy change prompted this reader to weigh in on what its enforcement, which has been pushed back to as late as 2013, could do for the banking industry:

“Convergence” between U.S. accounting practices and international accounting practices (from the International Accounting Standards Board) is to be implemented in one year. As part of this convergence, U.S. banks must soon begin to revalue (lower) assets on their books at current market value (mark-to-market).

Questions regarding defensive investing in uncertain times continue to fill the Money Morning Mailbag as readers aim to gain more knowledge on protective investment choices like real estate investment trusts, options-straddle strategies and dividend stocks.

In Tuesday’s Money Morning article “Defensive Investing: Seven Signs Your Dividend is in Trouble,” Contributing Editor Martin Hutchinson detailed how high-yield dividend stocks provide a remedy for market volatility. They generate a yield or capital gains when the market is flat or gently rising, and offer protection against a market decline.

“Dividend-paying stocks provide better long-term returns in all but the most extreme bull markets,” Hutchinson said. “Build yourself a diversified portfolio of solid dividend payers and you’ll be exceptionally well protected.”

Companies consistently paying dividends are less likely to have dramatic share-price declines. Meanwhile, investors who go after short-term gains can be left empty-handed when the stock market reverses.

BP PLC (NYSE ADR: BP) stock plunged 16% to hit a 14-year low in New York trading Wednesday as some investors panicked over growing liabilities and others worried about socially responsible investing.  

In London trading Thursday BP fell 6.7% to 365.50 pence, its lowest closing price since January 2003 and 44% lower than the day the Deepwater Horizon rig exploded.

“The share price is political and in no way fundamental,” said Jason Kenney, an analyst at ING Wholesale Banking in Edinburgh. “The U.S. needs to realize it needs BP to survive to clean up the mess. Scapegoating has gone too far.”

The threat of deflation has been making its rounds as inflationary measures like the consumer price index (CPI) fell for the first time in 13 months in April, dropping 0.1%. Core CPI – which excludes food and energy prices – rose only 0.9%, its smallest gain since 1966. The producer price index (PPI) also dipped 0.1%.

“The recent trend in inflation has been swiftly to the downside,” Eric Green, chief U.S. rates strategist at TD Securities, told Reuters. “All measures of inflation are decelerating.”

Investment behavior has shown an anxious but mixed sentiment of hedging against both inflation and deflation: Demand for gold metal is outstripping supply by more than 1% per year and has pushed gold prices to record highs, while others have sought out both corporate bonds and U.S. Treasuries for safety.

Financial regulation overhaul cleared another hurdle last week when the Senate approved its financial reform bill. However, the inclusion of a derivatives trading restriction left Wall Street wondering why its political contributions weren’t doing the talking.

The financial industry was surprised when a provision created by Sen. Blanche Lincoln, D-AR, requiring banks to spin off their derivatives trading arms remained in the Senate’s proposal. Wall Street lobbyists are now reaching out to the members of the Senate and House conference committee who will reconcile the two bills. The Senate named its committee appointees Tuesday, which included Lincoln.

The Financial Services Roundtable, a lobbying group representing financial companies, has already started meeting with House members who it believes will be involved in the final process and could help cut the provision.